What Expenses Are Considered a Variable Cost?
Identify business expenses that change directly with your activity levels. Understand how these costs impact your operations and profitability.
Businesses manage expenses to operate and generate revenue. These costs are categorized by how they behave in relation to changes in activity levels. Understanding these classifications provides insights into a company’s financial structure and aids informed business decisions.
Defining Variable Costs
A variable cost is an expense that changes in direct proportion to a business’s production or sales volume. As more goods or services are produced or sold, these costs increase, and conversely, they decrease if production or sales decline. This concept applies to both manufacturing and service-oriented businesses. For example, if a company makes twice as many products, total variable costs will roughly double.
While total variable costs fluctuate with activity, the variable cost per unit remains constant within a relevant range. This distinction is important for financial analysis, as it allows businesses to predict how overall expenses will change with varying levels of output. Knowing the variable cost per unit helps in setting prices and understanding profitability at different production scales.
How Variable Costs Behave
Variable costs exhibit a dynamic relationship with a company’s operational activity. When a business increases its production or sales volume, total variable costs rise accordingly. Conversely, if production or sales decrease, total variable costs will fall. This direct proportionality means that if output doubles, total variable costs also approximately double.
Despite the fluctuation in total variable costs, the cost incurred for each individual unit of production or service generally stays the same. This consistent per-unit cost holds true within the “relevant range” of activity. The relevant range is the operational scope where assumptions about cost behavior, such as constant variable cost per unit, remain valid.
Common Examples of Variable Costs
Several types of expenses commonly classify as variable costs due to their direct link to production or sales volume.
- Raw materials: Costs increase with more products manufactured (e.g., wood for furniture, flour for baking).
- Direct labor: For employees paid hourly or by piece-rate, costs rise with production demands.
- Sales commissions: Payments directly correlate with sales volume or value.
- Packaging materials: Need scales directly with the number of products sold.
- Shipping costs: Scale directly with the number of products delivered.
Variable Costs Versus Fixed Costs
Understanding variable costs is enhanced by contrasting them with fixed costs, which behave differently in relation to activity levels. Fixed costs are expenses that do not change in total within a relevant range of activity, regardless of production or sales volume. Examples include rent for a factory, insurance premiums, and salaries of administrative staff.
The fundamental difference lies in their behavior: total variable costs fluctuate with output, while total fixed costs remain constant. As production increases, the fixed cost per unit decreases because the total fixed cost is spread over more units. Conversely, the variable cost per unit remains stable. For example, a company’s monthly rent remains the same whether it produces 100 units or 1,000 units, but the cost of raw materials will increase with each additional unit produced. Businesses must manage both types of costs to achieve profitability and make informed financial decisions.